Financial Regulation, the Pessimistic View

Satyajit Das, who knows more about derivatives than I know about anything, has a guest post on naked capitalism about derivatives regulation. The quick summary? Don’t bet on it.

“‘Holy water’, ‘hosanna’s’ or other utterances (based on particular religious convictions) will be sprinkled or said in the form of initiatives to improve disclosure, increase capital and a new centralised counterparty (‘CCP’) to reduce the risk of a major dealer failing. Fundamental issues – the use for derivative for speculation, mis-selling of instruments to less sophisticated market participants, complexity, valuation problems – will not be substantively addressed.”

In particular, Das points out that the industry is already aiming to weaken what regulations Treasury has proposed, including centralized clearing of standardized derivatives.

“On 17 September 2009, Robert Pickel, ISDA’s CEO, argued before the U.S. House Agriculture Committee: ‘Not all standardized contracts can be cleared.’ He argued that that even if they have standardized economic terms many derivatives contracts will be ‘difficult if not impossible to clear’ because the CCP depends on such factors as liquidity, trading volume and daily pricing. This would, Pickel argued, make ‘it difficult for a clearinghouse to calculate collateral requirements consistent with prudent risk management.’

“Dan Budofsky, a partner at Davis Polk & Wardwell LLP, who testified on behalf of the Securities Industry and Financial Markets Association, agreed that ‘it may be more appropriate for products that trade less frequently to trade over-the-counter.'”

How these debates work out will depend on a few Congressional committees and the regulatory agencies that end up writing the actual rules. That’s why it is important for these debates to happen in the full glare of public attention. Unfortunately, public attention has moved on, which is exactly what the industry is counting on.

I find it hard to believe that “trading volume” is a problem in a market that is, by some estimates, over 500 Trillion dollars annually. Perhaps the solution is merely to limit the size of the contracts, forcing the big players to enter the market, round up, and compete for all the contracts they need for their hedging or speculative purposes.

Other comment on original article:

“For banks, the Dr. Jekyll of derivative trading is the revenues that can be generated. The Dr. Hyde is the risks in derivative trading that are generally deferred into a Panglossian future “neverland” using complex models, based on arcane mathematics and confidence that only ignorance can support.”

I really don’t think that even the full glare of public attention is going to make much of a difference. The level of complexity is just too high for the public, and this battle will be fought between the financial industry and the blogosphere. It doesn’t seem as though the government wants to get involved.

Derivatives are lucrative business for the banks, and they will undoubtedly devote significant firepower to frustrating any meaningful reform.

That said, there are legitimate problems with the administration’s proposals for the derivatives market. The administration’s proposal would work out well if the derivatives market were a one-size-fits-all place, but it is not. There are vastly different participants with varied objectives and levels of sophistication.

I can’t see any reason why dealers and end-users, and systemically-important and non-systemically-important market participants, should be held to the same requirements with respect to collateral, for example. End-users need to hedge their portfolios, but they are not carrying the same kinds of risk.

I’m not sure what the point is to having central clearing for standard contracts and then having a shadow OTC market for everything else, if that is what is being proposed. What about issues like suitability and fraud? What kinds of incentives would this create?

One would have thought that there would have been a push for reform after LTCM, but instead we got the CFMA. Ironically, we’ll get more non-reform from the same exact architects as the last non-reform (Summers, Gensler). I’m not sure how many times we have to beat out collective head against the wall here.

I would say that whether or not banks support a proposed reform is probably a good criterion. But it should not be the only one. Good grief.

It’s good to see the banks even have a lobbyist on this site. The sad thing is other than her base salary at the bank she gets paid pro bono for her services. Doesn’t it give you a warm fuzzy in your heart??

I agree with Bond Girl. Non-standardized contracts with bona fide end users are extremely useful and should be allowed to function freely… but, contracts that are to be traded and where others that the original end-user will participate those should be subject to clear and simple standardization and centralized clearing, not only because of the issue of risks but also because this is what will allow the markets to trade them more efficiently.

I was referring to James’ frequent comment that one can gauge whether a reform will be effective by whether the banks resist it, actually.

The point is – regardless of the banks’ complaints – there are mechanical problems with the proposed reforms that anyone who has actually worked with derivatives can quickly identify. These reforms will not do much to counter the banks’ abusive practices, and they may in fact be onerous for non-bank market participants.

While I do find your name-calling highly entertaining, it would be nice if every once in a while you backed it up with something of substance.

Bond Girl:
Most of your comments are badly masked arguments against ANY financial reform. If you were serious about it you would have said it as such “If the banks are against a reform, then probably it is a good reform”. You said it in a vague way and hence your need to clarify. Also you seem to argue that only those who work with derivatives know how to regulate them. More typical bankers propaganda. Just be honest and state what you REALLY are. Walks like a bank lackey, talks like a bank lackey, must be…………..

I assume you work for banks, by your name. Most likely a bond-rating agency. I’ll let people judge how valuable your assessments are on that. Because based on your field’s show of valuation, If my comments got a triple A rating from you Bond Girl, I’d be very worried about my future.

Ideas for effective reforms are going to come from people who take the time to cultivate a very specific, functional understanding of a topic. That does not require that someone have direct experience in the market, but I imagine it certainly helps with the more complex products. I am very much a proponent of reform.

Since this seems to be an issue, I have said here before that, in the past, I have managed money at one of the major investment banks. I currently work as a debt analyst with a large bond and interest rate derivative portfolio, but not on behalf of a bank. I do not and have never worked for a rating agency. I am not sure where you get that impression, as I have been very critical of rating agencies and the use of their ratings as proxies for genuine credit analysis.

I have no idea how it is that you have come to single me out as a target on this site or what you get out of this, but I am not interested in indulging you further. I’m afraid I’ve already stooped to your level.